The term proportional method refers to an approach used to allocate a lump-sum sale to one or more classes of securities. If the fair market value of each type of security is known, the proportional method calls for the allocation of the proceeds to each class of security based on its proportion of the total.
Allocation to Security = Fair Market Value of Security / Total of Lump-Sum Sale
Normally, companies will sell common stock, bonds, and preferred shares separately. This allows the company to accurately allocate the proceeds received to each class of security on its balance sheet. Occasionally, a company will bundle two or more classes of securities in exchange for a lump sum payment of cash or even an asset. A lump-sum sale of securities oftentimes occurs when one company acquires another.
Transactions involving a lump-sum sale present the company with an accounting challenge, since the proceeds from the sale must be allocated to each class of security on the company's balance sheet. Generally, there are two methods a company can use to calculate this allocation: the proportional and incremental methods.
The preferred approach is the proportional method, if the fair market value of each security involved in the lump-sum sale is known. The proportional approach uses a ratio of the value of each type of security to allocate the lump-sum sale to the proper accounts on the company's balance sheet.
Company XYZ has agreed to sell its transformer business to Company A. Company A has offered Company XYZ 22,000 shares of its common stock with a market value of $40.00 per share, along with 2,000 shares of preferred stock with a market value of $100.00 per share. Company A values the transformer business at $1,000,000, paying a small premium to Company XYZ. Since the value of each type of security is known in this lump-sum sale, Company A's accounting department will be using the proportional method to allocate the purchase price as shown in the table below.
|Fair Market Value of Common Stock (22,000 shares at $40.00 per share)||$880,000|
|Fair Market Value of Preferred Stock (2,000 shares at $100.00 per share)||$200,000|
|Fair Market Value of Lump-Sum Purchase||$1,080,000|
|Allocation to Common Stock ($880,000 / $1,080,000) x $1,000,000||$814,815|
|Allocation to Preferred Stock ($200,000 / $1,080,000) x $1,000,000||$185,185|
|Total Allocation of Lump-Sum Purchase||$1,000,000|